Foreign direct investment and corruption

DISSERTATION

FOREIGN DIRECT INVESTMENT AND CORRUPTION

Submitted by
Ferry Ardiyanto
Department of Economics

In partial fulfillment of the requirements
For the Degree of Doctor of Philosophy
Colorado State University
Fort Collins, Colorado
Fall 2012

Doctoral Committee:
Advisor: Harvey Cutler
Elissa Braunstein
Ramaa Vasudevan
Stephen Koontz


ABSTRACT

FOREIGN DIRECT INVESTMENT AND CORRUPTION

Corruption is the abuse of public authority and discretion for private gain. Corruption is
perceived as detrimental to investment as it acts like a tax on investment by increasing the cost of
doing business. However, the efficient grease hypothesis argues that corruption could increase
investment as it acts as grease money that enables firms to avoid bureaucratic red tape and
expedite the decision making process.
This study attempts to build empirical models to investigate the relationship between

foreign direct investment (FDI) and corruption and identify the determinants of corruption itself.
As tolerance towards corruption tends to vary from country to country, countries are
disaggregated into developed economies and developing economies. Additionally, there are four
regions within the developing economies group to take into account intrinsic differences in
perceptions of and attitudes towards corruption, as well as cultural and geographical differences.
The dissertation finds that corruption is deleterious for FDI inflows in developed
countries, but is somewhat beneficial for attracting FDI inflows in developing economies.
However, when developing countries are disaggregated into several regions, the effect of
corruption on FDI inflows fades away. Furthermore, corruption can be caused by both economic
and institutional factors. It is also confirmed that factors influencing corruption vary among
developed countries, developing countries and within regions of developing countries. The
importance of institutional factors makes it clear that the institutional framework is important for
explaining corruption, no matter whether a country is a developed or developing one.

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ACKNOWLEDGEMENTS

I would like to express my deepest gratitude to my advisor and the chair of my
dissertation committee, Professor Harvey Cutler, for his valuable guidance and very helpful
discussion. His contributions to this dissertation are greatly appreciated and will never be
forgotten. I would also like to thank the members of my dissertation committee, Professor Elissa
Braunstein, Professor Ramaa Vasudevan, and Professor Stephen Koontz for their constructive
comments and suggestions. I am especially indebted to Fulbright Program for providing me with
financial support throughout my study. Lastly, heartfelt thanks are extended to my family and my
friends for their constant support and encouragement.

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TABLE OF CONTENTS

ABSTRACT………………………………...…………………..…………………………..…….ii
ACKNOWLEDGEMENTS ………………………………………...……………………………iii
LIST OF TABLES………………………………...…………………………………………..…vii
LIST OF FIGURES ………………………………………...…………………………………..viii
Chapter 1. Introduction…..…………………………………………………………………….1
1.1. Background………………..……………………………………………………….…...1
1.2. Organization of the study…………………………..…………………………………...6
Chapter 2. Literature Review.........…………………………………...………………….…...11
2.1. FDI theories……………...…………………………………………………………....12
2.1.1. The monopolistic advantages theory………………………………………….…12
2.1.2. Transaction cost and internalization theory…..………………………………….16
2.1.3. Ownership, location, and internalization (OLI) advantages theory….………......18
2.1.4. Product life cycle (PLC) theory…..…………………………………………...…20
2.1.5. Horizontal FDI, vertical FDI and knowledge-capital theory…….....….……...…23
2.2. Types of FDI: horizontal, vertical and export-platform…….….……………………....26
2.3. Theoretical framework of corruption………….………………………….…………....30
2.4. Empirical findings………..…..………………………………………………………...43
2.4.1. The effect of corruption on FDI……………………………..…………………...43
2.4.2. The determinants of corruption………….…....………………………………….47
Chapter 3. Data and Methodology……….………...…………………………………………53
3.1. How to measure FDI inflows………..……………………………….………………...54
3.2. How to measure corruption……..………………………………………………….…..56
3.3. Explanatory variables for FDI equation…..………………………….………………...62

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3.4. Explanatory variables for corruption equation……………………………….….…….66
3.5. Country sample……………………………….……………………….……………….74
3.6. Panel data………………………………………….………………………….….…….75
Chapter 4. The Effect of Corruption on FDI Inflows..……………………….………….…..80
4.1. Preliminary results of OLS fitted line………………………………………...……….80
4.2. Theoretical model…………………………………………………..………...……….88
4.3. Empirical framework……………………………………………..…………..……….94
4.4. Developed and developing countries: results and discussions ……………...………..99
4.4.1. Model 1…………………………………………………...……………………...99
4.4.2. Model 2.…………………………………………………..…………………….106
4.4.3. Model 3……………………………………..……………………………….….107
4.4.4. Model 4……………………..……………………………………………..……108
4.4.5. Model 5……………………..……………………………………………..……109
4.5. Regions within developing countries category: results and discussions..……...……109
4.5.1. Africa……………………………………………………...……………………109
4.5.2. Latin America and the Caribbean.………………………..…………………….112
4.5.3. Asia and Oceania.………………………………………………………….…...115
4.5.4. Southeast Europe and the CIS……………………………………………..……119
Chapter 5. The Determinants of Corruption.………………………………………….…..124
5.1. Developed and developing countries: results and discussions ……………...………127
5.1.1. Model 1…………………………………………………...…………………….127
5.1.2. Model 2.…………………………………………………..…………………….132
5.1.3. Model 3…………………………………………………………………….…...133
5.1.4. Model 4……………………..……………………………………………..……135
5.2. Regions within developing countries category: results and discussions……...…..…139
5.2.1. Africa……………………………………………………...……………………139

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5.2.2. Latin America and the Caribbean.………………………..…………………….143
5.2.3. Asia and Oceania.………………………………………………………….…...148
5.2.4. Southeast Europe and the CIS…………………………………………………..156
Chapter 6. Concluding Remarks………………………………………………………….....163
6.1. Summary of findings………………………..………………………………...……...163
6.2. Policy recommendations………………………………………..………...…….……165
6.3. Suggestions for future research………………………………..……………..………170
References………………………………………………………….……………………...…...172

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LIST OF TABLES

1.1. Top Twenty FDI Flows Destination, 2010 and 2009………………………..……..…….….4
1.2. TI Corruption Index, 2010 and 2009.…………………………………………………….….5
3.1. Summary of Data Sources……………….………………………………………………....74
4.1. FDI Inflows and Corruption: Developed and Developing Countries…………………..…..98
4.2. Differing Productivities in the United States and China……………………………..……105
4.3. FDI Inflows and Corruption: Africa…………………………….………………...…..…..110
4.4. FDI Inflows and Corruption: Latin America and the Caribbean .………………...…..…..112
4.5. FDI Inflows and Corruption: Asia and Oceania………………...………………...…..…..116
4.6. FDI Inflows and Corruption: Southeast Europe and the CIS………...…………...…..…..120
5.1. Determinants of Corruption: Developed and Developing Countries……………………...127
5.2. Determinants of Corruption: Africa.…………………………….………………...…..…..139
5.3. Determinants of Corruption: Latin America and the Caribbean .…….…………...…..…..144
5.4. Determinants of Corruption: Asia and Oceania………….……...………………...…..…..149
5.5. Determinants of Corruption: Southeast Europe and the CIS…….…...…………...…..…..157

vii

LIST OF FIGURES

2.1. Corruption without Theft…………………………...………………………..……..………37
2.2. Corruption with Theft…………………………...………………………..……...…..……..38
4.1. FDI Inflows and Corruption in Developed Countries...…………………..……..………….81
4.2. FDI Inflows and Corruption in Developing Countries...……………..……...…..……........82
4.3. FDI Inflows and Corruption in Africa...…………………..……...…..……….....................83
4.4. FDI Inflows and Corruption in Latin American and the Caribbean .……...…………….....84
4.5. FDI Inflows and Corruption in Asia and Oceania ………………….……..……..………...86
4.6. FDI Inflows and Corruption in Asia and Oceania excluding Hong Kong and Singapore….86
4.7. FDI Inflows and Corruption in Southeast Europe and the CIS………………………….....87

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Chapter 1
Introduction

1.1. Background
Corruption is the abuse of public authority and discretion for private gain. Corruption has
become an important topic among economists and international development institutions.1
Corruption is perceived as detrimental to investment as it acts like a tax on investment by
increasing the cost of doing business (Wei 2000; Svensson and Fisman 2000; Tanzi and Davoodi
1998, 1997). Corruption also reduces the private marginal product of capital, thus decreasing
private investment and lowering economic growth (Keefer and Knack 1996; Mauro 1995).
However, some say that corruption could have a positive effect on investment. The efficient
grease hypothesis argues that corruption could increase investment as it acts as grease money
that enables firms to avoid bureaucratic red tape and expedite the decision making process

(Huntington 1968; Leff 1964). As Elliot (1997: 186) points out “bribes are viewed not only as
reasonable but as enhancing efficiency in situations where red tape or state control of the
economy may be strangling economic activity”. Whether corruption is harmful or beneficial for
investment is therefore an empirical matter, which is a question this dissertation will address. In
particular, this dissertation will investigate the effect of corruption on foreign direct investment
(FDI).
The dissertation finds that corruption is deleterious for FDI inflows in developed
countries, but is somewhat beneficial for attracting FDI inflows in developing economies.
1

For example, the World Bank (1997) has identified corruption as among the greatest obstacles to economic and
social development since it undermines development by distorting the rule of law and weakening the institutional
foundation on which economic growth depends. Transparency International (2009) considers corruption to be “...one
of the greatest challenges of the contemporary world. It undermines good government, fundamentally distorts public
policy, leads to the misallocation of resources, harms the private sector and private sector development and
particularly hurts the poor.”

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However, when developing countries are disaggregated into several regions, the effect of
corruption on FDI inflows fades away. Furthermore, corruption can be caused by both economic
and institutional factors. It is also confirmed that factors influencing corruption vary among
developed countries, developing countries and within regions of developing countries. The
importance of institutional factors makes it clear that the institutional framework is important for
explaining corruption, no matter whether a country is a developed or developing one.
Meanwhile, global capital flows are acknowledged to positively affect the development
of a nation, channeling through technology transfer, capital investment, increased labor
productivity, and the financial sector (Goldin and Reinert 2005; Obstfeld 1998). One of the most
celebrated global capital flows is in the kind of foreign direct investment (FDI), which is “the

acquisition of more than 10 percent shares on the part of a firm in a foreign-based enterprise and
implies lasting interest in or effective managerial control over an enterprise in another country”
(World Bank 2010). 2 Rapid changes in international production systems—in which multinational
corporations (MNCs) continue to locate production or research facilities in countries with lowest
costs possible— make international border-crossing no longer relevant. On the other side, host
governments now consider even greater foreign direct investment (FDI) as one of the quickest
ways to achieve high growth, especially after looking at successful export-led growth strategies
and trade and investment liberalization programs pursued by East Asian countries. However,
corruption is still argued to be one of the main obstacles in undertaking FDI especially in
developing countries, although corruption could also be helpful when formal and informal

2

IMF (1993) labels foreign direct investment as investment aimed at obtaining a lasting interest by a resident entity
of one economy (direct investor) in an enterprise that is resident in another economy (the direct investment
enterprise). The “lasting interest” implies the existence of a long-term relationship between the direct investor and
the direct investment enterprise and a significant degree of influence on the management of the latter. IMF defines
the owner of 10% or more of a company’s capital as a direct investor (ibid).

2


institutions are weak since bribes might serve as “lubricants” in an otherwise sluggish economy. 3
Therefore, firms, consulting firms, researchers, and academia alike now pay more attention to
corruption, which may have a strong effect, whether it is negative or positive, on FDI.
According to World Investment Report 2011, the current FDI recovery is taking place in
the wake of a severe decline in FDI flows worldwide in 2009 due to the global recession. After a
16 percent decline in 2008, global FDI inflows fell a further 37 percent to $1.185 trillion in 2009,
but bounced back to $1.244 trillion in 2010, a moderate rise of 5 percent from previous year.
However, FDI flows in 2010 were still 15 percent below their pre-crisis level and 37 percent

below their 2007 peak. The recovery of FDI inflows in 2010 was stronger in developing
countries than in developed ones due to developing countries’ pace of growth and reform, fast
economic recovery, strong domestic demand, rapid growth in South-South FDI flows— and their
increased openness to FDI and international production. Consequently, developing and transition
economies now account, for the first time, for more than a half of global FDI inflows in 2010.
For many years, North American and Western European countries have received a large
share of FDI inflow. Nonetheless, there has been a significant shift of FDI inflows into
developing countries since the 1990s. Table 1.1 presents the top twenty host economies for FDI
inflows in 2009 and 2010. According to Table 1.1, the United States was still the largest
recipient of FDI inflows both in 2009 and 2010. However, in 2010, half of the top twenty host
economies were developing and transition countries. Additionally, three developing economies

3

Donor countries and development institutions have established guidelines for reducing corruption. For instance,
the World Bank’s Helping Countries Combat Corruption: The Role of the World Bank, September 1997 and
Organisation for Economic Cooperation and Development’s Convention on Combating Bribery of Foreign Public
Officials in International Business Transactions, November 1997. For one specific country, the Foreign Corrupt
Practices Act of 1977 prohibits U.S. firms from offering or making payment to foreign officials to secure any
improper advantage in order to obtain or retain business. Regardless of these sustained commitments and increased
efforts to contain corruption, today’s evidence shows that the intensity of corruption is far from subsiding and
maybe even worse in some developing countries.

3


ranked among the five largest FDI recipients in the world. Although the United States and China
maintained their top positions, some European countries became less popular for attracting FDI
inflows.
Table 1.1. Top Twenty FDI Flows Destination, 2010 and 2009

(billions of US dollars)
United States

228

153

China

95

Hong Kong

69

52

Belgium

62

24

Brazil

48

26

Germany

38

United Kingdom

46
46

Russian Federation

36

Singapore

106

71

41

39

15

France

2010

34
34

Australia

26

Saudi Arabia

2009

32

28
32

Ireland

26
26

India

25

Spain

25

9

Canada

36

23
21

Luxembourg

20

Mexico

19
15

Chile

30

15
13

Indonesia

5

13

0

50

100

150

200

250

Source: UNCTAD 2011, Figure I.4

To get a quick glimpse of the level of corruption across countries, Table 1.2 presents the
Corruption Perceptions Index from Transparency International (TI) —hereinafter referred to as
the TI corruption index or TI index for short— for the top twenty FDI destinations for 2010 and
2009. TI publishes this corruption index annually since 1995 and defines corruption as "the

4


misuse of public power for private benefit." TI ranks countries by their perceived levels of
corruption— not absolute levels of corruption because of measurement difficulty due to the
secretive nature of corruption— as determined by expert assessments and opinion surveys. As of
2011, TI ranks 182 countries on a scale from 10 (very clean) to 0 (highly corrupt).
Table 1.2. TI Corruption Index, 2010 and 2009
(10: very clean, 0: highly corrupt)
United States

7.1

China

7.5

3.5
3.6

Hong Kong

8.4
8.2

Belgium

2010

7.1
7.1

Brazil

3.7
3.7

2009

Germany

7.9
8.0

United Kingdom

7.6
7.7

Russian Federation

2.1
2.1

Singapore

9.3
9.2

France

6.8
6.9

Australia

8.7
8.7

Saudi Arabia

4.3

4.7

Ireland

8.0
8.0

India

3.3
3.4

Spain

6.1
6.1

Canada

8.9
8.7

Luxembourg

8.2

Mexico

8.5

3.1
3.3

Chile

6.7

Indonesia

7.2

2.8
2.8

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Source: Transparency International 2010

If corruption is perceived as harmful to investment— it is expected that the less
corruption a country has; the more investment will pour in, ceteris paribus. Based on Table 1.2,
this proposition holds true when applied to United States, Hong Kong, Singapore, Chile, Canada,

5


Australia, Belgium, Germany, United Kingdom, and some other Western European countries.
But what about China, Brazil, India, Russian Federation, and some other emerging economies?
According to Table 1.2, China was relatively corrupt with average score of 3.5 in 2010 and 3.6 in
2009 but it was the second most popular destination of FDI in the world. India was worse than
China in terms of corruption, but still it was better at attracting FDI than Spain, Canada, and
Luxembourg, which are less corrupt. The Russian Federation was even more corrupt than India
but it was still pulling significant amount of FDI inflows, even larger than those of India. Brazil
was more corrupt than Singapore, Canada, Saudi Arabia, Chile, Belgium, and other Western
European countries, but it fared better in gaining a share of FDI than those latter countries except
Belgium. Overall, corruption has a restrictive as well as an expansionary economic effect. We
will empirically investigate the effect of corruption on FDI at large by taking into account other
variables believed to be important determinants of FDI. Additionally, we will examine the
determinants of corruption itself empirically by considering both economic and institutional
variables.

1.2. Organization of the study
The dissertation consists of six chapters. Chapter 1 presents background information on
FDI and corruption. It presents the recent trends in FDI flows and corruption. We see that there
is some consistency between the level of FDI inflows and the level of perceived corruption. The
less corrupt they are, the more FDI coming in. Most developed countries and some developing
countries, particularly Hong Kong, Singapore, and Chile get this result straight. However, we
also go over some contradiction for most developing countries among the top twenty FDI

6


destinations. Investment keeps pouring in although they are relatively corrupt. The organization
of the dissertation concludes Chapter 1.
Chapter 2 is a literature review on FDI and corruption. It starts with a discussion about
the academic theories of why firms engage in FDI and how firms can successfully produce goods
and services in remote and unfamiliar business environments. There are five dominant theories:
the monopolistic advantage theory, transaction cost and internalization theory, ownership,
location, and internalization (OLI) advantages theory, product life cycle theory, and horizontal
FDI, vertical FDI, and knowledge-capital. There is also a discussion about the types of FDI
based on its role in the parent company’s global production strategy. Next, we discuss
corruption. The role of corruption either as a grabbing hand or a helping hand will be elaborated
upon. Corruption may deter FDI inflows as it increases cost of doing business. Moreover, bribes
also decrease the expected profitability of investment and the private marginal product of capital,
thus decreasing private investment and then lowering economic growth (Keefer and Knack 1996;
Mauro 1995). However, bribes may be also helpful in countries with very long customs-waiting
times at the border or with a low quality of customs service (Lui 1985). Corruption could also be
considered a useful substitute for a weak rule of law if the value of behaving corruptly—the
value of additional productive transactions occurred—exceeds the costs of engaging in
corruption (Bardhan 1997). The previous empirical research on the effects of corruption on FDI
and the determinants of corruption end Chapter 2.

Chapter 3 explains the data and methodology used in the dissertation. In the first section,
we elaborate upon several ways to measure FDI inflows and corruption, along with some options
on data sources. Then, we discuss the reasons why certain independent variables should be
included. To explain FDI, there are standard independent economic variables such as GDP per

7


capita, exports, inflation, investment, FDI inflows in previous year, and population. Labor
productivity is the variable representing labor market factor. Civil liberties include the freedom
of expression and belief, associational and organizational rights, rule of law, and personal
autonomy and individual rights. For the corruption equation, there are some economic variables
as well. The institutional variables will be added progressively. The summary of data sources
concludes the first section. The second section explains the methodology. We explore the
advantages and disadvantages of using panel data, which is the type of data used in this
dissertation. Next, we look at the choice of appropriate econometric technique to run the
regression. Because autocorrelation and heteroskedasticity are two common problems in panel
data, the feasible generalized least squares (FGLS) estimator is preferred. The FGLS estimator
allows estimation in the presence of autocorrelation of type AR (1) within panels,
contemporaneously cross-sectional correlation, and heteroskedasticity across panels (Greene
2008).
Chapter 4 investigates the empirical relationship between FDI inflows and corruption in
developed and developing economies, including regions within developing countries. First, we
plot FDI inflows against corruption to find the fitted line in order to get a quick look at whether
corruption could be detrimental or beneficial for FDI inflows. Then, we present the theoretical
model for explaining the relationship between FDI and corruption. Corruption, in terms of
bribery, might be good for FDI because more bribery could lower real red tape. However, firms
that pay more bribes could wind up spending more management time to negotiate with a corrupt
government officer— and therefore face higher costs. Next, we demonstrate the empirical
investigation of the relationship between FDI (the dependent variable) and corruption using the

benchmark model. The benchmark model includes the following explanatory variables:

8


institutional quality (corruption), market size (GDP per capita), export capacity (exports per
capita), demography (population), and labor efficiency (labor productivity). Other explanatory
variables will be added progressively to the benchmark model: economic stability (inflation),
investment capacity (investment as a percent of GDP), agglomeration (past FDI inflows), and
institutional freedom (civil liberties). The discussion of the regression results is elaborated upon
based on region, starting with developed countries and developing countries, and ending with
each region within developing countries.
Chapter 5 examines the determinants of corruption empirically. The perceived corruption
level in host countries will be treated as endogenous. Variation in corruption levels across
countries is argued to be mainly due to differences in economic factors and institutional quality.
In assessing the level of economic development, I focus on the rate of growth of GDP. As the
incentive to engage in corrupt practices increases with the availability of rents, I include
government consumption expenditures per capita, openness, and endowment of natural
resources. All those variables— in sum — become the explanatory variables in the benchmark
model. Institutional variables will be added to the benchmark model gradually. The first
institutional variable to be included is economic freedom, which broadly measures the ability of
citizens and companies within a country to carry out economic activities without being
obstructed by the state. The second institutional variable is civil liberties since more civil
liberties increase the ability of civil society to monitor and legally limit government officials
from engaging in rent seeking behavior. The last institutional variable to be taken into account is
the level of democracy because political competition, through democratic elections, brings on
stronger public pressure against corruption.

9

Chapter 6 is the concluding remarks. It presents a set of conclusions based on empirical
findings of the effect of corruption on FDI and the determinants of corruption. Chapter 6 also
offers policy recommendations. Suggestions for future research conclude the chapter.

10


Chapter 2
Literature Review

Why do firms want to invest abroad by setting up plants or subsidiaries in host countries
rather than exporting goods produced at their home plants? The reasons are obvious. Having a
plant abroad reduces transportation costs and some types of transaction costs. Firms can avoid
any tariff and nontariff barriers from exporting to the host county. Firm can also take advantage
of lower wages and access to raw materials in host countries especially in developing economies.
Better customer service and product management are expected as sellers are closer to the
customers. An alliance between the production divisions of firms also allows technical expertise
to be shared and possible duplication of products is avoided (Feenstra and Taylor 2012: 21).
The first part of this chapter explores the academic theories why firms engage in FDI and
how firms can successfully produce goods and services in remote and unfamiliar business
environment. In FDI literature, there are basically five dominant theories: (1) the monopolistic
advantage theory; (2) transaction cost and internalization theory; (3) ownership, location, and
internalization (OLI) advantages theory; (4) product life cycle theory, and; (5) horizontal FDI,
vertical FDI, and knowledge-capital. There are also discussions about the types of FDI based on
the role in the parent company’s global production strategy.
The second part of the chapter discusses corruption. The role of corruption either as a
grabbing hand or a helping hand will be elaborated. Corruption may deter FDI inflows as it
increases the cost of doing business. Moreover, bribes also decrease the expected profitability of
investment and the private marginal product of capital, thus decreasing private investment and

then lowering economic growth (Keefer and Knack 1996: Mauro 1995). However, corruption
may increase investment as it acts as grease money that enables firms to circumvent troublesome
11


red tape. Bribes may be also helpful in countries with very long waiting-times at the border or
with a low quality of customs service (Lui 1985). Corruption could also be considered a useful
substitute for a weak rule of law if the value of behaving corruptly—the value of additional
productive transactions that occurr—exceeds the costs of engaging in corruption (Bardhan 1997).
The previous empirical research on the effect of corruption on FDI and the determinants of
corruption itself conclude this chapter.

2.1. FDI theories
2.1.1. The monopolistic advantages theory
The first modern theory of FDI can be traced back to Stephen Hymer. In his 1960’s
dissertation (published posthumously in 1976), he uses industrial organization and imperfect
competition theories to explain firms’ motivation to perform FDI. Hymer (1960) starts his theory
with an analysis of the special features of the multinational corporations (MNCs) that are not
possessed by their domestic counterparts. Those MNCs specific advantages include but are not
limited to brand names, trademarks, management and marketing skills, restricted or advanced
technologies, access to low-cost financing, and economies of scale.
The possession of these advantages is indispensable for foreign firms to perform FDI
because they are at a disadvantage compare to local firms. Local firms have advantages over
foreign firms because they know the local environment better. They have knowledge of local
market conditions, the legal and institutional framework of doing business, and local business
customs. Of course, foreign firms can get all the knowledge possessed by local firms, but only at
cost and this cost may be considerable.

12

Furthermore, foreign firms incur costs from operating at a distance because they are
concerned with the difficulties of operating in the host country’s unfamiliar business practices.
Therefore, if FDI should occur and be profitable, it must be the case that foreign firms have
certain advantages over the local firms. And some market imperfections must impede local
firms’ access to foreign firms’ advantages. Therefore, FDI can be considered as a strategic action
by the firm to take advantage of market imperfections and also an instrument to avoid market
imperfections.
Hymer also mentions the difference between two kinds of long term private international
capital movements – direct investment and portfolio investment. The difference is the issue of
control. Control is defined as occurring if the investors own twenty five percent of the equity of
the foreign firm (Hymer 1976: 1). If the investor directly controls the foreign enterprise, Hymer
called it a direct investment. On the other hand, if the investor has less than twenty five percent
of the equity or does not control it, the investment is termed a portfolio investment. It is carried
out mainly to exercise gains from interest rate differentials, capital gains, and diversification of
market risk through purchases of bonds and stocks.
Hymer (1976: 33) claims that the circumstances causing a firm to control an enterprise in
foreign countries are for one minor reason and two major reasons. The minor reason is
diversification. He considered it minor because it is not necessarily to establish control. It is
primarily to smooth shocks by promoting risk sharing. By diversifying their portfolios, firms
own not only the income streams from their own capital stocks, but also income streams from
capital stocks of foreign firms. On the other hand, the major reasons are as follows:

13


1. Often it is profitable to control firms in more than one country in order to eliminate
competition between them.
2. Some firms have advantages in some certain activities and they may find it tempting to
exploit these advantages by establishing foreign operations.

Kindleberger (1969: 33) also argues that FDI occurs in the absence of conditions of
perfect competition because when perfect competition conditions exist, local firms would have
advantages over foreign firms due to the proximity of their operation to their decision making
centers. Therefore, no firms could survive in foreign operation. For FDI to flourish there must be
some imperfections in markets for goods or factors. Kindleberger (1969) presents the
characteristics of monopolistic advantages that induce FDI as follows:
1. Imperfections in the goods markets associated with product differentiation, superior
managerial and marketing skills and collusion in pricing.
2. Imperfections in factor markets because of patented and proprietary technology, preferential
access to borrowed capital and management and engineering skills.
3. Internal and external economies of scale that lead to no other choice for MNCs but to expand
by producing and marketing on a multinational basis.
4. Market distortions created by government that influence monopolistic advantages, for
instance tariffs, quotas, subsidies to favored industry or other nontariff barriers.
The more significant the advantages due to those market imperfections, the greater the
likelihood that monopoly profits will be earned and the more the firms are motivated to engage
in FDI. When there are no imperfections, FDI will not occur. International production would be
undertaken through some market arrangements, for example export and import, licensing,
turnkey projects, management and marketing contracts, franchising and offshoring.
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Caves (1974, 1971) considers product differentiation in the home market as the vital
element giving rise to FDI. The MNC’s possession of intangible assets allows it to differentiate
products in different markets and secure cash flows streams. These intangible assets are termed
“unique assets”. The connection between the firm’s unique assets, including its technology and
management superiority, and the level of foreign involvement is confirmed (Caves 2007). The
firms that aggressively seek overseas investment are generally the leading firms in their
industries. They invest more in research and development, put massive effort into marketing and
advertising, employ many scientists, engineers, and professional staff, sell some distinctive

products and have easy access to market distribution networks.
Caves also distinguishes between horizontal FDI, vertical FDI, and conglomeration.
Horizontal FDI is doing roughly the same production activities in many countries. Vertical FDI
is locating different stages of production in different countries. On the other hand,
conglomeration is basically producing many products in many countries. For horizontal FDI, he
highlights the importance of product differentiation. According to him, it is the horizontally
integrated firm that has unique assets over it local counterparts. When the product is protected by
patents or trademarks, it is difficult for local competitors to produce exactly the same product.
When a product is created using a combination of superior managerial and production skills,
innovative production processes, financial advantages and access to production factors, then it is
not easy for local competitors to mimic the product using their resources.
For vertically integrated firms, the possession of unique assets is not binding so much
because the motivation for foreign production is to avoid uncertainty regarding the availability
and pricing of its production inputs. He assumes that the production units of vertically integrated
firm are dispersed in different countries because of conventional location pressures. Vertically

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integrated firms also perform international production in order to establish barriers to entry for
new competitors.
Spreading of business risks is the main explanation for conglomeration, in which multiple
international plants have no evident horizontal or vertical relationship (ibid). Doing international
production in any form brings some diversification gains to the firm. These gains are widened
when firms could diversify across product and geographical spaces. Diversified foreign
investment is also partly motivated by the parent company’s efforts to utilize its diverse research
and development discoveries.

2.1.2. Transaction cost and internalization theory
Transaction cost and internalization theory was initially developed by Ronald Coase. His

main purpose was to explain why economic activity was organized within firms. Coase (1937)
argues that firms exist because they reduce the transaction costs, which arise during production
and exchange, capturing efficiencies that individuals are not capable of. These transaction costs
are organized more efficiently within the institution of the firm. However, according to him,
there are also internal costs of the firm, which are mainly associated with the diminishing rate of
return when a firm expands above certain scale and the inefficient allocation of resources as a
result of the absence of a price mechanism to direct all economic activities (ibid).
Williamson (1985, 1975) extends Coase’s ideas by treating the firm as a governance
structure and by identifying the particular transaction characteristics that play a crucial role in
comparative institutional assessment. Williamson argues that there are costs to using the market,
thus in order to avoid these costs, the transactions could be performed within the firm (ibid).
However, then there will be internal organization costs incurred. Given different costs associated

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with the market channel and internal organization, it is the transaction cost minimization that
determines which transaction cost is used for each transaction. A channel is selected for one
particular type of transactions when it is cheaper than the others. When the internal organization
is less costly and thus preferred, it supersedes the market and directs economic activities and
resource allocation. The transaction cost approach provides a conceptual framework to explain
the operation of the MNCs. FDI, in this approach, is considered to be an economic instrument to
bypass international markets and internalize transactions within the firm.
McManus (1972) highlights the role of transaction costs in the development of foreign
operations by recognizing the existence of main interdependencies between activities conducted
in different countries and the need to coordinate the activities of the interdependent parties. He
argues that in order to successfully coordinate economic agents in different countries, firms can
use strategies as follows:
1. Decentralized decision making by utilizing the price mechanism.
2. Contractual agreements, such as licensing, franchising, marketing contract, management

contracts and international subcontracting.
3. Internalization of transactions within a single institution, through the establishment of an
international firm.
The first strategy, by using the price mechanism, will incur costs because there are
transaction costs that come from the need to specify the attributes of the good to be exchanged or
from the difficulties in quantifying the flows of services or assets being exchanged (ibid). When
the transaction costs are high or prohibitive, then MNCs exist. The MNC, then, arises as a
response to market failures, as a way to increase allocative efficiency when the cost of
coordinating economic activity between independent economic agents is high.
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